Simon: A 1987 Success Story

Simon had a view. A good trader always starts with a thesis.

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I worked with a very intelligent man at Morgan Stanley. Let's call him Simon. He was a salesman on the institutional desk and covered several large trading accounts. He was well suited for this because he thought outside of the box and was a contrarian by nature. His specialty was technical analysis, but he could converse intelligently on just about any financial level. Most importantly, he was a very good guy.

In the summer of 1987 he made a call. I have talked previously about the extremely cheap level of options. Simon recognized the huge level of leverage in the system and when rates began to creep up, he went out to his trading accounts and made them aware of the extreme danger he saw in the market. He understood the connection between leverage and volatility, or the potential for it. This was no normal call: Simon was saying that there was a reasonable potential for a cataclysmic fall in the market.

I mentioned that he was a good guy, so he told his story to all of us. The beauty of the situation was that the opinion coincided with a very cheap way to trade it. The market had gone through five years of option selling. Institutional accounts had been making money for years selling calls against long stock and now the most leveraged of all participants, market makers, were getting in on the action. It was easy money to sell out of the money puts, regardless of price, and watch them go to zero.

Simon recommended to accounts and friends and family alike to buy six month 10% out of the money puts and wait. In today's market this would cost around 1% of the price of the index. In 1987 the cost was a mere 0.02%.

Simon went out and bought 2000 of these puts for $0.0625 for a total cost of $12,500. He bought them for his mother too. There were several traders on the desk who bought them as well.

When the market began to correct in October, all the traders who had bought them were tripping over themselves to sell their puts at $0.25, some even waiting until $0.50. Clearly all thought this was a normal correction and were quick to lock in their profits.

Not Simon. Simon had a view. A good trader always starts with a thesis. Simon was carefully and unemotionally watching what was going on, continually re-evaluating the trade within the context of the market action. I imagine that the others selling quickly out of their positions was a data point for him.

The puts went to $1, then $5, then $10. Simon hadn't sold a one yet. Some traders quietly advised Simon to sell "at least some" to lock in a profit. Simon thanked them for their advice, but did nothing. I can remember a feeling of incredulousness began to creep up on the desk. People were shaking their heads. How could Simon be so irresponsible with his (and his mother's) money?

Late in the day before the day of the crash, Simon began to sell a few puts. He finished selling them the day of the crash when the market was paying any price to buy in puts. Simon's average price on the sale of the puts was $59. I imagine the price was the same for his mother.

One of the biggest mistakes for a trader is to exit a position too early. This is an easy route and one that leads most to fail in trading. The great traders I know have the ability to maximize profits and minimize losses. It is necessary to take profits, of course, but good traders do it in the context of portfolio profits and losses: if the portfolio is doing well, profits can be ridden more aggressively; when the portfolio is doing poorly, it is necessary to be more conservative.

Despite extreme pressure from all sides Simon held on. In fact, it was probably because of this pressure that he held on. Simon thought clearly through the whole process, recognizing the forest from the trees. Every data point convinced him that this was no mere correction. He was in the middle of the trade of his life and he knew it.

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